The Discipline Of the Dollar

See if you can identify the following country: Its currency is falling sharply in global markets; its speculative real estate bubble has burst; its financial sector is weakened by bad loans and lack of transparency. This economy is teetering on the edge of recession, and, thanks to borrowing so heavily abroad, its economic future is at the mercy of international creditors.

I'm talking about Thailand, of course, as it stood 10 years ago -- on the edge of the devastating Asian financial crisis. But if that description bears more than a little resemblance to the United States today, then I have made my point: We have reached a junction in international financial markets -- and whether this produces a smooth transition or a convulsive crisis will be shaped by decisions made in coming months.

To a jaundiced eye, the telling difference between Thailand and the United States is how their foreign debts are denominated. Thailand, like most countries, must borrow abroad in foreign currencies. If the value of the Thai baht sinks, then it becomes more expensive to repay loans made in euros or yen.

But the United States, as a financial superpower, has the luxury of borrowing abroad in its own currency. The Chinese, who are sitting on $1.4 trillion in foreign reserves, hold much of that in Treasury securities and other dollar investments. This cushion tends to mask our financial weakness -- and to lessen the natural correctives that would keep America from borrowing and spending more than it can afford.

"If you're borrowing in foreign currencies, you can literally run out of cash and hit a brick wall," explains Jeffrey Sachs, who heads Columbia University's Earth Institute. "What we can't do is run out of dollars, so we have a degree of freedom."

If America were Thailand, the International Monetary Fund would long ago have imposed austerity conditions that forced us to put our financial house in order. The IMF's intervention a decade ago was punishing: Banks were forced to close; interest rates were pushed up to punitive levels; economic activity was squeezed almost to the point of strangulation. The IMF may have overreacted, but the austerity measures did wring the speculative excesses out of the Asian economies. Today, they are booming like never before.

America illustrates the old saw about how a debt can grow so big it becomes the bank's problem rather than the borrower's. The United States is running a current account deficit of roughly $800 billion a year, nearly 6 percent of our gross domestic product. But the world keeps accepting our dollars as IOUs because the alternative would be disastrous for everyone. Kenneth Rogoff, a former chief economist at the IMF who teaches at Harvard, notes that if the United States were unable to fund its debt, world economic output could fall by as much as 25 percent.

But a global financial adjustment is underway, nonetheless. The clearest sign is the fall in the dollar. The greenback has declined 16 percent against a trade-weighted basket of currencies over the past year and 26 percent since 2000.

The sinking dollar is often described as a problem, but it's actually part of the cure -- not as harsh as the IMF's austerity measures for Asian countries a decade ago but not painless, either. Over time, a cheaper dollar will boost U.S. exports and may even reduce our seemingly insatiable appetite for imports, which won't be quite so cheap as before. Meanwhile, the problems in the housing sector may make U.S. consumers a bit less spendthrift, and we may begin saving more as a country.

If the world were populated by Adam Smiths, these natural market mechanisms would produce the gradual adjustments that are needed. But in real life, markets are inhabited by versions of TV financial analyst Jim Cramer -- emotional, volatile traders whose passions are triggered by good or bad news. They overreact, and markets overshoot.

So what's ahead in this season when markets are repricing currencies and financial risks? Here's the Adam Smith version: As the dollar falls, China and other Asian nations will begin adjusting their portfolios so that they accumulate fewer dollars. The value of their artificially pegged currencies will finally rise against the dollar. Over time, the U.S. trade deficit will shrink, and the dollar eventually will begin to rise again.

Then there's the Jim Cramer version: As the dollar falls, the gradual adjustment will turn into a stampede, with investors fleeing dollars for the safety of other currencies. The Fed will have to raise interest rates, consumers will stop spending and America will sink into recession. In that bleak market scenario, the United States might resemble Thailand of 1997 more than we'd like to imagine.

The writer is co-host of PostGlobal, an online discussion of international issues. His e-mail address isdavidignatius@washpost.com.